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Saving or Investing: Can you beat inflation?

As of August 2012, instant access accounts offered just 0.22% interest and deposit accounts 1.51%. Meanwhile cash ISAs offered an average of just 0.66% while fixed-term savings bonds paid more, but only 2.49% a year.

Virtually all policies offered less than inflation which means that using most savings or deposit accounts at the moment guarantees that you will lose some of the real value of the cash you put in.

What can you do?

Using any spare cash to pay off debts, especially expensive ones such as credit cards, is sensible, and instant access to some savings legislates for an unexpected bill. After that, if you are able to put money away for a few years, you could consider investing.

Mr Bond says... "An investment in retail bonds may allow an investor to benefit regardless of the performance of the company in which he is invested"

In light of the volatility experienced in the last few years, you could be forgiven for thinking that stock markets are casinos where the brave or foolhardy can make a quick buck, and that cash on deposit represents the safe and sensible choice for those more interested in long-term accumulation of capital or enjoying a steady income.

However, evidence shows that most stock markets have delivered returns well ahead of inflation over almost all periods of 10 years or more with the key factor being the steady accumulation (and compounding) of the dividends paid to shareholding investors by most quoted companies.

An investment in retail bonds may allow an investor to benefit regardless of the performance of the company in which he is invested with the degree of certainty that a coupon and guaranteed maturity value brings rather than less predictable dividends and value of the underlying share price.

Value of dividends

The key value is that the multiplying effect of compound interest applies when reinvesting dividends which represents by far the largest part of the real increase in value (i.e. after inflation) that stock markets can deliver.

Over the space of 10 years, an average return of just over 7% a year from investing will double your original sum. Given that it is possible to achieve dividend returns of 3-4% a year from investing in shares, then very modest increases in share prices each year can top that up, and make that 7% target achievable. The yield for recent retail bond issues can be considered in this context. Companies that produce a strong and reliable dividend stream have usually also delivered much better than average total returns – i.e. adding increase in share prices to their dividends.

Real businesses

Stock market returns have usually done a better job than cash on deposit at preserving value against inflation which is not surprising if we think about what a share is: it is a slice of a real business that earns profits by providing customers with goods or services. If inflation means increases in the price of goods and services, it follows that owning a slice of the profits will give some natural protection from inflation whereas cash on deposit is often more susceptible to having value gradually eroded by inflation.

Investing in bonds amounts to having an IOU with predetermined terms from a government or company, which may be considered as involving less risk; of course, all investment necessarily involves risk of many sorts which makes it important to consider which risks matter most to you.

Risks

If the key risk is the value of your investment falling by 10% or even 30% in a year, then cash on deposit is probably still a good choice and shares a bad choice. By contrast, if the key risk you worry about is the post-inflation value of your savings falling by 50% over the next decade or two, or if you fear being unable to live on the poor returns from even the best savings policies, then cash looks a bad choice and stock markets a better one.

Studying the past does not let us predict the future, but evidence suggests that:-

Mixing different types of investment together can reduce, but never eliminate, most types of risk

A steady dividend income is much more important and more reliable than sudden capital gains

Keeping down all investment costs is usually very important to long-term returns

Rapid trading (particularly if it amounts to 'buying high and selling low', as it often does) is one of the surest ways to increase the risk of disaster.

So, how does a sensible investor start investing in the stock market?

One way to do it is to invest in a selection of the hundreds of investment trusts and thousands of unit trusts available which include low cost index-tracking choices for those who do not think that they can pick a better-than-average investment manager.

Mr Bond says... "Retail bonds may prove attractive in the current climate, and may be held within a Stocks and Shares ISA to protect from income and capital gains tax."

Investment trusts are, in short, listed firms that invest in the shares of other companies; unit trusts are collective funds that allow investors to pool their money in a single fund.

Retail bonds may prove attractive in the current climate, and may be held within a Stocks and Shares ISA to protect from income and capital gains tax.

Auto-enrolment

No investment strategy is guaranteed to succeed, but the rational case for investing your long-term savings will come to the fore for many millions of people in the next few years when the government's landmark policy of auto-enrolment will see these people contributing to a pension for the first time, with contributions from their employers.

These funds will, in the vast majority of cases, be put into investment funds linked to the stock market and government or company bonds. Knowing why that is being done with their hard-earned cash will help them understand if their money is being well invested or not, will help them know what to expect, and perhaps more significantly decide whether or not to take control of their own savings and investment strategy.